**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-Q**

 

| **ý** | ** ** | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934.**                                                                                                       |
|------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|       |       |                                                                                                                                                                                                           |
| ** ** | ** ** | **For the quarterly period  ended September 30, 2005.**                                                                                                                                                   |
|       |       |                                                                                                                                                                                                           |
| **OR**     |
|       |       |                                                                                                                                                                                                           |
| **o**      | ** ** | **TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934.**                                                                                                       |
|       |       |                                                                                                                                                                                                           |
| ** ** | ** ** | **For the  transition period  from              to              ** |

 

**CommissionFile Number: 1-11388**

 

**PLC SYSTEMS INC.**

(Exact Name ofRegistrant as Specified in Its Charter)

 
| **Yukon  Territory, Canada**                | ** ** | **04-3153858**                        |
|---------------------------------------------|------------|---------------------------------------|
| (State or Other  Jurisdiction of            |       | (I.R.S. Employer  Identification No.) |
| Incorporation or  Organization)             |       |                                  |
|                                        |       |                                  |
| **10  Forge Park, Franklin, Massachusetts** | ** ** | **02038**                             |
| (Address of  Principal Executive Offices)   |       | (Zip Code)                            |

 

Registrant’stelephone number, including area code: **(508) 541-8800**

 

Indicateby check mark whether the registrant: (1) has filed all reports requiredto be filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days. **Yes  ****ý****  No  ****o**

 

Indicateby check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2of the Exchange Act)  **Yes  ****o****  No  ****ý**

 

Indicateby check mark whether the registrant is a shell company (as defined in Rule 12b-2of the Exchange Act)  **Yes  ****o****  No  ****ý**

 

Indicate the number ofshares outstanding of each of the issuer’s classes of common stock, as of thelatest practicable date.

 
| **Class**                   | ** ** | **Outstanding at November 7, 2005** |
|-----------------------------|------------|------------------------------------------|
| Common Stock, no  par value |       | 30,078,775                               |

 

 

----

 

**PLCSYSTEMS INC.**

 

**Index**

 
| Part I.  | Financial Information: |                                                                                        |
|---------------|------------------------|---------------------------------------------------------------------------------------------|
|          |                   |                                                                                        |   |
|          | Item 1.                | Financial Statements                                                                        |   |
|          |                   |                                                                                        |   |
|          |                   | Condensed  Consolidated Balance Sheets (unaudited)                                          |   |
|          |                   |                                                                                        |   |
|          |                   | Condensed  Consolidated Statements of Operations (unaudited)                                |   |
|          |                   |                                                                                        |   |
|          |                   | Condensed  Consolidated Statements of Cash Flows (unaudited)                                |   |
|          |                   |                                                                                        |   |
|          |                   | Notes  to Condensed Consolidated Financial Statements (unaudited)                           |   |
|          |                   |                                                                                        |   |
|          | Item 2.                | Management’s Discussion and  Analysis of Financial Condition and Results of Operations |   |
|          |                   |                                                                                        |   |
|          | Item 3.                | Quantitative and Qualitative  Disclosures about Market Risk                                 |   |
|          |                   |                                                                                        |   |
|          | Item 4.                | Controls and Procedures                                                                     |   |
|          |                   |                                                                                        |   |
| Part II. | Other Information:     |                                                                                        |
|          |                   |                                                                                        |   |
|          | Item 6.                | Exhibits                                                                                    |   |

 

2

----

 

**Item 1.****    FinancialStatements**

 

**PLCSYSTEMS INC.**

CONDENSEDCONSOLIDATED BALANCE SHEETS

(In thousands)

(Unaudited)

 
| ** **                                                                                                                                                          | ** ** | **September 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| **ASSETS**                                                                                                                                                          |       |                         |       |                        |       |
| Current assets:                                                                                                                                                     |       |                         |       |                        |       |
| Cash and cash  equivalents                                                                                                                                          |       | $                            | 2,817      |                        | $          | 9,678 |   |
| Short-term  investments                                                                                                                                             |       | 5,400                        |       | —                      |       |
| Accounts  receivable – Edwards                                                                                                                                 |       | 917                          |       | 1,144                       |       |
| Accounts  receivable – other, net of allowance of $86 and $104 as of September 30,  2005 and December 31, 2004, respectively                         |       | 151                          |       | 261                         |       |
| Inventories, net                                                                                                                                                    |       | 985                          |       | 1,112                       |       |
| Prepaid expenses  and other current assets                                                                                                                          |       | 739                          |       | 592                         |       |
| Total current  assets                                                                                                                                               |       | 11,009                       |       | 12,787                      |       |
|                                                                                                                                                                |       |                         |       |                        |       |
| Long-term  investments                                                                                                                                              |       | 1,500                        |       | —                      |       |
| Equipment,  furniture and leasehold improvements, net                                                                                                               |       | 248                          |       | 293                         |       |
| Other assets                                                                                                                                                        |       | 229                          |       | 247                         |       |
| Total assets                                                                                                                                                        |       | $                            | 12,986     |                        | $          | 13,327 |   |
|                                                                                                                                                                |       |                         |       |                        |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                       | ** ** | ** **                   | ** ** | ** **                  | ** ** |
| Current  liabilities:                                                                                                                                               |       |                         |       |                        |       |
| Accounts payable                                                                                                                                                    |       | $                            | 360        |                        | $          | 328 |   |
| Accrued  compensation                                                                                                                                               |       | 666                          |       | 430                         |       |
| Accrued other                                                                                                                                                       |       | 331                          |       | 301                         |       |
| Deferred revenue  – Edwards                                                                                                                                    |       | 1,426                        |       | 999                         |       |
| Deferred revenue  – other                                                                                                                                      |       | 67                           |       | 71                          |       |
| Total current  liabilities                                                                                                                                          |       | 2,850                        |       | 2,129                       |       |
|                                                                                                                                                                |       |                         |       |                        |       |
| Deferred revenue  – Edwards                                                                                                                                    |       | 4,018                        |       | 4,181                       |       |
| Deferred revenue  – other                                                                                                                                      |       | 188                          |       | 188                         |       |
| Total long-term  liabilities                                                                                                                                        |       | 4,206                        |       | 4,369                       |       |
|                                                                                                                                                                |       |                         |       |                        |       |
| Commitments and  contingencies                                                                                                                                      |       |                         |       |                        |       |
|                                                                                                                                                                |       |                         |       |                        |       |
| Stockholders’  equity:                                                                                                                                         |       |                         |       |                        |       |
| Preferred stock,  no par value, unlimited shares authorized, none issued and outstanding                                                                            |       | —                       |       | —                      |       |
| Common stock, no  par value, unlimited shares authorized, 30,079 and 30,068 shares issued and  outstanding as of September 30, 2005 and December 31, 2004 |       | 93,737                       |       | 93,731                      |       |
| Accumulated  deficit                                                                                                                                                |       | (87,453                      | )          | (86,582                     | )          |
| Accumulated  other comprehensive loss                                                                                                                               |       | (354                         | )          | (320                        | )          |
| Total  stockholders’ equity                                                                                                                                    |       | 5,930                        |       | 6,829                       |       |
| Total  liabilities and stockholders’ equity                                                                                                                    |       | $                            | 12,986     |                        | $          | 13,327 |   |

 

The accompanying notesare an integral part of the condensed consolidated financial statements.

 

3

----

 

**PLCSYSTEMS INC.**

CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands,except per share data)

(Unaudited)

 
| ** **                           | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|--------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                           | ** ** | **2005**                                   | ** ** | **2004**                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
| Revenues:                            |       |                                       |       |                                      |       |   |   |   |   |
| Product sales –  Edwards        |       | $                                          | 1,352      |                                      | $          | 1,022 |   | $ | 4,198 |   | $ | 3,608 |   |
| Product sales –  other          |       | 183                                        |       | 199                                       |       | 462 |   | 498 |   |
| Service fees –  Edwards         |       | 313                                        |       | 344                                       |       | 984 |   | 1,005 |   |
| Service fees –  other           |       | 52                                         |       | 41                                        |       | 181 |   | 200 |   |
| Total revenues                       |       | 1,900                                      |       | 1,606                                     |       | 5,825 |   | 5,311 |   |
|                                 |       |                                       |       |                                      |       |   |   |   |   |
| Cost of revenues:                    |       |                                       |       |                                      |       |   |   |   |   |
| Product sales –  Edwards        |       | 564                                        |       | 256                                       |       | 1,580 |   | 1,284 |   |
| Product sales –  other          |       | 68                                         |       | 123                                       |       | 204 |   | 260 |   |
| Service fees –  Edwards         |       | 153                                        |       | 139                                       |       | 435 |   | 426 |   |
| Service fees –  other           |       | 30                                         |       | 32                                        |       | 114 |   | 93 |   |
| Total cost of  revenues              |       | 815                                        |       | 550                                       |       | 2,333 |   | 2,063 |   |
|                                 |       |                                       |       |                                      |       |   |   |   |   |
| Gross profit                         |       | 1,085                                      |       | 1,056                                     |       | 3,492 |   | 3,248 |   |
|                                 |       |                                       |       |                                      |       |   |   |   |   |
| Operating expenses:                  |       |                                       |       |                                      |       |   |   |   |   |
| Selling, general  and administrative |       | 739                                        |       | 886                                       |       | 2,516 |   | 2,742 |   |
| Research and  development            |       | 810                                        |       | 616                                       |       | 2,030 |   | 1,661 |   |
| Total operating  expenses            |       | 1,549                                      |       | 1,502                                     |       | 4,546 |   | 4,403 |   |
| Loss from operations                 |       | (464                                       | )          | (446                                      | )          | (1,054 | ) | (1,155 | ) |
| Other income, net                    |       | 67                                         |       | 30                                        |       | 183 |   | 138 |   |
| Loss before income taxes             |       | (397                                       | )          | (416                                      | )          | (871 | ) | (1,017 | ) |
| Provision for income taxes           |       | —                                     |       | 20                                        |       | — |   | 20 |   |
| Net loss                             |       | $                                          | (397       | )                                         | $          | (436 | ) | $ | (871 | ) | $ | (1,037 | ) |
| Basic and diluted loss per share     |       | $                                          | (0.01      | )                                         | $          | (0.01 | ) | $ | (0.03 | ) | $ | (0.03 | ) |
| Average shares outstanding:          |       |                                       |       |                                      |       |   |   |   |   |
| Basic and  diluted                   |       | 30,079                                     |       | 30,059                                    |       | 30,073 |   | 30,013 |   |

 

The accompanying notesare an integral part of the condensed consolidated financial statements.

 

4

----

 

**PLCSYSTEMS INC.**

CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)

 
| ** **                                                                                  | ** ** | **Nine Months Ended  September 30,** | ** ** |
|---------------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                                  | ** ** | **2005**                                  | ** ** | **2004** | ** ** |
| Operating activities:                                                                       |       |                                      |       |   |   |
| Net loss                                                                                    |       | $                                         | (871       | ) | $ | (1,037 | ) |
|                                                                                        |       |                                      |       |   |   |
| Adjustments to  reconcile net loss to net cash provided by (used for) operating activities: |       |                                      |       |   |   |
| Depreciation and  amortization                                                              |       | 96                                        |       | 103 |   |
|                                                                                        |       |                                      |       |   |   |
| Change in assets  and liabilities:                                                          |       |                                      |       |   |   |
| Accounts  receivable – Edwards                                                         |       | 227                                       |       | 534 |   |
| Accounts  receivable – other                                                           |       | 117                                       |       | 24 |   |
| Inventories                                                                                 |       | 126                                       |       | (451 | ) |
| Prepaid expenses  and other assets                                                          |       | (147                                      | )          | 30 |   |
| Accounts payable                                                                            |       | 33                                        |       | 180 |   |
| Deferred revenue  – Edwards                                                            |       | 263                                       |       | 4,487 |   |
| Deferred revenue  – other                                                              |       | 2                                         |       | 23 |   |
| Accrued  liabilities                                                                        |       | 267                                       |       | 108 |   |
| Net cash provided by operating activities                                                   |       | 113                                       |       | 4,001 |   |
|                                                                                        |       |                                      |       |   |   |
| Investing activities:                                                                       |       |                                      |       |   |   |
| Purchase of  investments                                                                    |       | (8,400                                    | )          | — |   |
| Maturity of  investments                                                                    |       | 1,500                                     |       | — |   |
| Purchase of  equipment                                                                      |       | (32                                       | )          | (146 | ) |
| Net cash used for investing activities                                                      |       | (6,932                                    | )          | (146 | ) |
|                                                                                        |       |                                      |       |   |   |
| Financing activities:                                                                       |       |                                      |       |   |   |
| Net proceeds  from sales of common shares                                                   |       | 6                                         |       | 90 |   |
| Net cash provided by financing activities                                                   |       | 6                                         |       | 90 |   |
|                                                                                        |       |                                      |       |   |   |
| Effect of exchange rate changes on cash and cash  equivalents                               |       | (48                                       | )          | (12 | ) |
| Net increase (decrease) in cash and cash equivalents                                        |       | (6,861                                    | )          | 3,933 |   |
|                                                                                        |       |                                      |       |   |   |
| Cash and cash equivalents at beginning of period                                            |       | 9,678                                     |       | 6,377 |   |
| Cash and cash equivalents at end of period                                                  |       | $                                         | 2,817      |   | $ | 10,310 |   |

 

The accompanying notesare an integral part of the condensed consolidated financial statements.

 

5

----

 

**PLCSYSTEMS INC.**

NOTES TO CONDENSEDCONSOLIDATED FINANCIAL STATEMENTS

September 30,2005

 

***1.******            ******Natureof Business***

 

PLCSystems Inc. (“PLC” or the “Company”) is a medical device company specializingin innovative technologies for the cardiac and vascular markets.  The Company currently manufactures lasers foruse in the treatment of cardiovascular disease. PLC pioneered the *CO2 Heart LaserSystem* (the “Heart Laser System”) that cardiac surgeons use toperform carbon dioxide (CO2) transmyocardial revascularization (“TMR”)to alleviate symptoms of severe angina.

 

Edwardsacts as the Company’s exclusive distributor for TMR products in the UnitedStates. Edwards is also the Company’s largest shareholder, owning approximately18% of its outstanding common stock as of September 30, 2005, and has arepresentative on the Board of Directors.

 

***2.******            ******Basis of Presentation***

 

The accompanyingunaudited condensed consolidated financial statements of the Company have beenprepared in accordance with generally accepted accounting principles forinterim financial information and with the instructions to Form 10-Q and Article 10of Regulation S-X.  Accordingly, they donot include all of the information and footnotes required by generally acceptedaccounting principles for complete financial statements.  In the opinion of management, all adjustments(consisting of normal recurring adjustments) considered necessary for a fairpresentation have been included. Operating results for the three and nine months ended September 30, 2005 are not necessarily indicative of the results that maybe expected for the year ending December 31, 2005.  These financial statements should be read inconjunction with the consolidated financial statements and footnotes thereto includedin the Company’s Annual Report on Form 10-K for the year ended December 31,2004.  Certain prior year amounts havebeen reclassified to conform to the current year’s presentation.

 

***3.******    ******Edwards Transaction***

 

InFebruary 2004, the Company signed an agreement with Edwards to assumedevelopment of the Optiwave 980 cardiac laser ablation system (“Optiwave 980System”).  Under the terms of theagreement, the Company will have exclusive manufacturing rights to build theOptiwave 980 System and other related surgical products if offered commerciallyby Edwards. The Company would be responsible, among other things, for ongoingresearch and development and manufacture of the product and for obtainingregulatory approvals.  Edwards would beresponsible for the approval, funding and conduct of any clinical studiesdesigned to obtain data in support of a new product approval or clearance asrequired by the FDA or other regulatory body and would act as the exclusiveworldwide distributor for all surgical cardiac ablation products.

 

Inconjunction with signing this agreement, the terms of the Company’s TMRdistribution agreement with Edwards were modified to (1) extend the term ofthe agreement until at least

 

6

----

 

October 17, 2017 and (2) reduce the Company’s share ofrevenue on TMR kits sold to hospitals. The Company received as considerationfrom Edwards, a lump-sum payment of $4,533,333, which was recorded as deferredrevenue in the Company’s Consolidated Balance Sheet.  See Note 8, “Revenue Recognition”.

 

***4.******             Lossper Share***

 

Forthe three and nine months ended September 30, 2005 and 2004, basic anddiluted loss per share have been computed using only the weighted averagenumber of common shares outstanding during the period without giving effect toany potential future issuances of common stock related to stock option programsand warrants, since their inclusion would be antidilutive.

 

Forthe three months ended September 30, 2005 and 2004, 5,818,422 and 6,190,422shares, respectively, and for the nine months ended September 30, 2005 and2004, 5,818,422 and 6,190,422 shares, respectively, attributable to outstandingstock options and warrants were excluded from the calculation of diluted lossper share because the effect was antidilutive. The following table sets forth the computation of basic and diluted lossper share:

 
| ** **                                              | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|---------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                              | ** ** | **2005**                                   | ** ** | **2004**                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                              | ** ** | **(In thousands, except loss per share)**  | ** ** |
| Net loss available for common shareholders              |       | $                                          | (397       | )                                         | $          | (436 | ) | $ | (871 | ) | $ | (1,037 | ) |
| Weighted average outstanding shares of common stock     |       | 30,079                                     |       | 30,059                                    |       | 30,073 |   | 30,013 |   |
| Dilutive effect of employee stock options and  warrants |       | —                                     |       | —                                    |       | — |   | — |   |
| Common stock and common stock equivalents               |       | 30,079                                     |       | 30,059                                    |       | 30,073 |   | 30,013 |   |
| Loss per share:                                         |       |                                       |       |                                      |       |   |   |   |   |
| Basic                                                   |       | $                                          | (0.01      | )                                         | $          | (0.01 | ) | $ | (0.03 | ) | $ | (0.03 | ) |
| Diluted                                                 |       | $                                          | (0.01      | )                                         | $          | (0.01 | ) | $ | (0.03 | ) | $ | (0.03 | ) |

 

***5.******             Stock-BasedCompensation***

 

The Company grants stock options for a fixed numberof shares to employees and certain other individuals with exercise prices equalto the fair value of the shares at the dates of grant. The Company has adoptedthe disclosure-only provisions of Statement of Financial Accounting Standards No. 123,*Accounting for Stock-based Compensation*(“SFAS 123”), as amended, and presently accounts for its stock option plans inaccordance with the provisions of Accounting Principles Board Opinion 25, *Accounting for Stock Issued to Employees*(“APB 25”).

 

The following tableillustrates the effect on net loss and basic loss per share if the Company hadapplied the fair value recognition provisions of SFAS 123 to stock-basedemployee compensation:

 

7

----

 
| ** **                                                                                                           | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                                                           | ** ** | **2005**                                   | ** ** | **2004**                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                                                           | ** ** | **(In thousands, except per share data)**  | ** ** |
| Net loss  attributable to common stockholders— As reported                                                      |       | $                                          | (397       | )                                         | $          | (436 | ) | $ | (871 | ) | $ | (1,037 | ) |
| Deduct total  stock-based compensation expense determined under fair value based method for  all stock option awards |       | (10                                        | )          | (39                                       | )          | (176 | ) | (431 | ) |
| Net loss attributable  to common stockholders—Pro forma                                                         |       | $                                          | (407       | )                                         | $          | (475 | ) | $ | (1,047 | ) | $ | (1,468 | ) |
| Loss per basic  and diluted share attributable to common stockholders— As reported                              |       | $                                          | (0.01      | )                                         | $          | (0.01 | ) | $ | (0.03 | ) | $ | (0.03 | ) |
| Loss per basic  and diluted share attributable to common stockholders— Pro forma                                |       | $                                          | (0.01      | )                                         | $          | (0.02 | ) | $ | (0.03 | ) | $ | (0.05 | ) |

 

The Company did not grantany stock options during the quarter ended September 30, 2005 or 2004.Therefore, there were no assumptions of expected life, interest rate,volatility or expected dividend yield with respect to the Black-Scholes modelfor such periods.

 

For the nine months endedSeptember 30, 2005 and 2004, the fair value of issued options at the date ofgrant was estimated using the Black-Scholes model with the following weightedaverage assumptions:

 

| ** **              | ** ** | **Nine Months Ended** | ** ** |
|-------------------------|------------|-----------------------|------------|
| ** **              | ** ** | **September 30,**     | ** ** |
| ** **              | ** ** | **2005**              | ** ** | **2004** | ** ** |
| Expected life (years)   |       | 3                     |       | 3 |   |
| Interest rate           |       | 3.68                  |       | 1.47 - 2.53 |   |
| Volatility              |       | .407                  |       | .734 - .803 |   |
| Expected dividend yield |       | N/A                   |       | N/A |   |

 

***Recent Accounting Pronouncement***

 

On December 16, 2004, theFinancial Accounting Standards Board (“FASB”) issued SFAS No. 123 (revised2004), *Share-Based Payments* (“SFAS 123R”),which is a revision of SFAS No. 123. SFAS 123R supersedes APB 25. SFAS123R requires all share-based payments to employees, including grants ofemployee stock options, to be recognized in the income statement based on theirfair values. The disclosure-only approach permitted by SFAS 123 and elected bythe Company is no longer an alternative. Accordingly, the adoption of SFAS 123R’sfair value method may have a significant impact on the results of operations,although it will have no impact on the Company’s overall financial position.The impact of adoption of SFAS 123R cannot be predicted at this time because itwill depend on levels of share-based payments granted in the future. However,had the Company adopted SFAS 123R, the impact of that standard likely wouldhave approximated the impact of the fair value recognition provision of SFAS123 as described in the disclosure of pro forma net income and earnings pershare above. The Company is required to adopt the provisions of SFAS 123Reffective January 1, 2006.

 

***6.******             ComprehensiveLoss***

 

Total comprehensive lossfor the three and nine month periods ended September 30, 2005 amounted to $400,000and $905,000, respectively, as compared to $440,000 and $1,047,000,respectively, for the three and nine month periods ended September 30,2004.  Comprehensive loss is comprised ofnet loss plus the increase/decrease in currency translation adjustment.

 

***7.******             Inventories***

 

Inventories are stated at the lower of cost or market using the first-in,first-out (FIFO) method and consist of the following (in thousands):

 

8

----

 

| ** **       | ** ** | **September 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|------------------|------------|------------------------------|------------|-----------------------------|------------|
| Raw materials    |       | $                            | 747        |                        | $          | 889 |   |
| Work in progress |       | 139                          |       | 130                         |       |
| Finished goods   |       | 99                           |       | 93                          |       |
|             |       | $                            | 985        |                        | $          | 1,112 |   |

 

At September 30, 2005 and December 31, 2004, inventories arestated net of a reserve of $537,000 and $528,000, respectively, for potentiallyobsolete inventory.

 

***8.******             RevenueRecognition***

 

TheCompany records revenue from the sale of TMR kits and Optiwave 980 Systems atthe time of shipment to Edwards.  TMR kitrevenues include the amount invoiced to Edwards for kits shipped pursuant topurchase orders received, as well as an amortized portion of deferred revenuerelated to Edwards’ payment of $4,533,333 in February 2004.  This payment was made by Edwards in exchangefor a reduction in the prospective purchase price the Company receives fromEdwards upon a sale of the kits (see Note 3). The Company is amortizing this payment from Edwards into itsConsolidated Statement of Operations as revenue over a seven year period underthe units-of-revenue method as prescribed by Emerging Issues Task Force (EITF)88-18, *Sales of Future Revenue*.  Management determined that a seven yeartimeframe was the most appropriate amortization period based on a valuationmodel they used to assess the economic fairness of the payment. Factorsmanagement considered in developing this valuation model included the estimatedforegone revenues over a seven year period resulting from the reduction in theprospective purchase price payable to the Company by Edwards, a discount ratedeemed appropriate to the transaction and an estimate of the remaining economicuseful life of the current TMR kit design, without any benefit being given topotential future product improvements the Company may make. For the three and ninemonths ended September 30, 2005, the Company has recorded amortization of$89,000 and $263,000, respectively.

 

TMRlasers are billed to Edwards in accordance with purchase orders that theCompany receives. Invoiced TMR lasers are recorded as other current assets anddeferred revenue on the Company’s Consolidated Balance Sheet until such time asthe laser is shipped to a hospital, at which time the Company records revenueand cost of revenue.

 

Underthe terms of the Edwards TMR distribution agreement, once Edwards has recovereda prescribed amount of revenue from a hospital for the use or purchase of a TMRlaser, any additional revenues earned by Edwards are shared with the Companypursuant to a formula established in the distribution agreement. The Companyonly records its share of such additional revenue, if any, at the time therevenue is earned.

 

The Company recordsrevenue from the sale of TMR kits and TMR lasers to international distributorsor hospitals at the time of shipment.

 

Revenues from service and maintenance contracts arerecognized ratably over the life of the contract.

 

9

----

 

Installation revenues related to a TMR lasertransaction are recorded as a component of service fees when the laser isinstalled.

 

# ***9.****            **Warranty and PreventativeMaintenance Costs*

# ** **

TheCompany warranties its products against manufacturing defects under normal useand service during the warranty period. The Company obtains similar warranties from a majority of its suppliers,including those who supply critical Heart Laser System components.  In addition, under the terms of its TMRdistribution agreement with Edwards, the Company is able to bill Edwards foractual warranty costs, including preventative maintenance services, up to aspecified amount during the warranty period.

 

TheCompany evaluates the estimated future unrecoverable costs of warranty andpreventative maintenance services for its installed base of lasers on aquarterly basis and adjusts its warranty reserve accordingly.  The Company considers all available evidence,including historical experience and information obtained from supplier audits.

 

Changes in the warrantyaccrual were as follows (in thousands):

 
| ** **                                                 | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                 | ** ** | **2005**                                  | ** ** | **2004** | ** ** |
| Balance, beginning of period                               |       | $                                         | 60         |   | $ | 60 |   |
| Payments made                                              |       | —                                    |       | — |   |
| Change in liability for warranties issued during the  year |       | 10                                        |       | 7 |   |
| Change in liability for preexisting warranties             |       | (10                                       | )          | (7 | ) |
|                                                       |       |                                      |       |   |   |
| Balance, end of period                                     |       | $                                         | 60         |   | $ | 60 |   |

 

**Item 2.****        Management’sDiscussion and Analysis of Financial Condition and Results of Operations**

 

This quarterly report(including certain information incorporated herein by reference) containsforward-looking statements within the meaning of Section 27A of theSecurities Act of 1933, as amended, and Section 21E of the SecuritiesExchange Act of 1934, as amended (the “Exchange Act”). Statements containingterms such as “believes”, “plans”, “expects”, “anticipates”, “intends”, “estimates”and similar expressions reflect uncertainty and are forward-looking statements.Forward-looking statements are based on current plans and expectations andinvolve known and unknown important risks and uncertainties that could causeactual results to differ materially from those described in the forward-lookingstatements. Such important factors and uncertainties include, but are notlimited to, those set forth below under the heading “Certain Factors that May Affectour Future Results” and elsewhere in this quarterly report.

 

# **Overview**

# ** **

Weare a medical device company specializing in innovative technologies for thecardiac and vascular markets.  Wecurrently manufacture lasers for use in the treatment of cardiovasculardisease.  Our Heart Laser Systems areused to treat patients with severe angina and the Optiwave 980 System, whencommercially introduced, is expected to be used to ablate cardiac tissue as a

 

10

----

 

means to treat certain heart arrhythmias.

 

Edwardsacts as our exclusive distributor for TMR products in the United States.Edwards is our largest customer, accounting for approximately 88% and 89%,respectively, of our total sales for the three and nine months ended September 30,2005 and 88% in the year ended December 31, 2004. We expect this salestrend to continue for the foreseeable future.

 

Approximately93% and 88%, respectively, of our revenues in the three and nine months ended September 30,2005 and 90% in the year ended December 31, 2004, came from the sale andservice of TMR lasers and related disposable kits. Although not a directmeasure, we believe a leading indicator of the adoption rate of TMR as atreatment for severe angina is TMR kit shipments to hospitals.  We remain largely dependent on the success ofEdwards’ sales and marketing efforts to increase our installed base of TMRlasers and increase TMR procedure volumes and revenues.

 

Ourmanagement reviews a number of key performance indicators to assist them in determininghow to allocate resources and run our day to day operations. These indicatorsinclude (1) actual prior quarterly sales trends, (2) projected TMRlaser and kit sales for the next four quarters, as provided by Edwards in arolling 12 month sales forecast, (3) research and development progress asmeasured against internal project plan objectives, (4) budget to actualfinancial expenditure results, (5) inventory levels (both our own andEdwards’) and (6) short term and long term projected cash flows of thebusiness.

 

**Applicationof Critical Accounting Policies and Estimates**

 

This management’sdiscussion and analysis of financial condition and results of operations isbased on our condensed consolidated financial statements, which have beenprepared in accordance with accounting principles generally accepted in theUnited States.  Our significantaccounting policies are more fully described in Note 2 of the Notes toConsolidated Financial Statements as well as in “Item 7 - Management’sDiscussion and Analysis of Financial Condition and Results of Operations –Critical Accounting Policies and Estimates”, each as contained in our AnnualReport on Form 10-K for the year ended December 31, 2004.  No significant changes were made to thosepolicies during the three months ended September 30, 2005.

 

# ***Inventories***

 

Inventoriesare stated at the lower of cost or market value.  A specific obsolescence allowance is providedfor slow moving, excess and obsolete inventory based on our best estimate ofthe net realizable value of inventory on hand taking into consideration factorssuch as (1) actual trailing 12 month sales, (2) expected futureproduct line demand, based in part on sales forecast input received fromEdwards, and (3) service part stocking levels which, in management’s bestjudgment, are advisable to maintain in order to meet warranty, service contractand time and material spare part demands. Historically, we have found our reserves to be adequate.

 

# ***Allowancefor Doubtful Accounts***

 

Forour accounts receivable, we continuously monitor collections from customers,our principal customer being Edwards, and we maintain a provision for estimatedcredit losses based

 

11

----

 

upon historical experience and any specific customer collection issuesthat we have identified.  Historically,we have not experienced significant losses related to our accountsreceivable.  Collateral is not generallyrequired. If the financial condition of our customers were to deteriorate,resulting in an impairment of their ability to make payments, additionalallowances may be required.

 

***Long-Term Investments***

 

Long-terminvestments consist of monies invested in bank certificates of deposit withremaining maturities greater than one year.

 

# ***Warrantyand Preventative Maintenance Costs***

# ** **

Wewarranty our products against manufacturing defects under normal use andservice during the warranty period.  Weobtain similar warranties from a majority of our suppliers, including those whosupply critical Heart Laser System components. In addition, under the terms of our TMR distribution agreement withEdwards, we are able to bill Edwards for actual warranty costs, includingpreventative maintenance services, up to a specified amount during the warrantyperiod.

 

Weevaluate the estimated future unrecoverable costs of warranty and preventativemaintenance services for our installed base of lasers on a quarterly basis andadjust our warranty reserve accordingly. We consider all available evidence, including historical experience andinformation obtained from supplier audits.

 

## ***Revenue Recognition***

## ** **

Werecord revenue from the sale of TMR kits and Optiwave 980 Systems at the timeof shipment to Edwards.  TMR kit revenuesinclude the amount invoiced to Edwards for kits shipped pursuant to purchaseorders received, as well as an amortized portion of deferred revenue related toEdwards’ payment to us of $4,533,333 in February 2004 in exchange for areduction in the prospective purchase price we receive from Edwards upon a saleof the kits. We are amortizing this payment from Edwards into our ConsolidatedStatement of Operations as revenue over a seven year period under theunits-of-revenue method as prescribed by Emerging Issues Task Force (EITF) 88-18,*Sales of Future Revenue*. We determinedthat a seven year timeframe was the most appropriate amortization period basedon a valuation model we used to assess the economic fairness of the payment.Factors we considered in developing this valuation model included the estimatedforegone revenues over a seven year period resulting from the reduction in theprospective purchase price payable to us by Edwards, a discount rate deemedappropriate to the transaction and an estimate of the remaining economic usefullife of the current TMR kit design, without any benefit being given topotential future product improvements we may make. For the three and nine monthsended September 30, 2005, we recorded amortization of $89,000 and $263,000,respectively.

 

TMRlasers are billed to Edwards in accordance with purchase orders that wereceive. Invoiced TMR lasers are recorded as other current assets and deferredrevenue on our consolidated balance sheet until such time as the laser isshipped to a hospital, at which time we record revenue and cost of revenue.

 

12

----

 

Underthe terms of the Edwards TMR distribution agreement, once Edwards has recovereda prescribed amount of revenue from a hospital for the use or purchase of a TMRlaser, any additional revenues earned by Edwards are shared with us pursuant toa formula established in the distribution agreement. We only record our shareof such additional revenue, if any, at the time the revenue is earned.

 

We record revenue from thesale of TMR kits and TMR lasers to international distributors or hospitals atthe time of shipment.

 

Revenues from service and maintenance contracts arerecognized ratably over the life of the contract.

 

Installation revenues related to a TMR lasertransaction are recorded as a component of service fees when the laser isinstalled.

 

**Results of Operations**

 

Results for the three andnine months ended September 30, 2005 and 2004 and the related percent ofrevenues were as follows:

 
| ** **                                  | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|---------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                  | ** ** | **2005**                                   | ** ** | **2004**                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                  | ** ** | **$**                                      | ** ** | **%**                                     | ** ** | **$** | ** ** | **%** | ** ** | **$** | ** ** | **%** | ** ** | **$** | ** ** | **%** | ** ** |
| ** **                                  | ** ** | **(dollars in thousands)**                 | ** ** |
|                                        |       |                                       |       |                                      |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Total revenues                              |       | 1,900                                      |       | 100                                       |       | 1,606 |   | 100 |   | 5,825 |   | 100 |   | 5,311 |   | 100 |   |
| Total cost of  revenues                     |       | 815                                        |       | 43                                        |       | 550 |   | 34 |   | 2,333 |   | 40 |   | 2,063 |   | 39 |   |
| Gross profit                                |       | 1,085                                      |       | 57                                        |       | 1,056 |   | 66 |   | 3,492 |   | 60 |   | 3,248 |   | 61 |   |
| Selling,  general & administrative |       | 739                                        |       | 39                                        |       | 886 |   | 56 |   | 2,516 |   | 43 |   | 2,742 |   | 52 |   |
| Research &  development            |       | 810                                        |       | 43                                        |       | 616 |   | 38 |   | 2,030 |   | 35 |   | 1,661 |   | 31 |   |
| Loss from operations                        |       | (464                                       | )          | (24                                       | )          | (446 | ) | (28 | ) | (1,054 | ) | (18 | ) | (1,155 | ) | (22 | ) |
| Other income                                |       | 67                                         |       | 4                                         |       | 30 |   | 2 |   | 183 |   | 3 |   | 138 |   | 3 |   |
| Loss before  taxes                          |       | (397                                       | )          | (21                                       | )          | (416 | ) | (26 | ) | (871 | ) | (15 | ) | (1,017 | ) | (19 | ) |
| Provision for  income taxes                 |       | —                                     |       | —                                    |       | 20 |   | (1 | ) | — |   | — |   | 20 |   | 1 |   |
| Net loss                                    |       | (397                                       | )          | (21                                       | )          | (436 | ) | (27 | ) | (871 | ) | (15 | ) | (1,037 | ) | (20 | ) |

 

13

----

 
| ** **                                           | ** ** | **Three Months Ended  September 30,** | ** ** | **Increase (decrease)** | ** ** | **Nine Months Ended  September 30,** | ** ** | **Increase (decrease)** | ** ** |
|------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------|------------|-------------------------------------------|------------|-------------------------|------------|
| ** **                                           | ** ** | **2005**                                   | ** ** | **2004**                | ** ** | **over 2004**                             | ** ** | **2005**                | ** ** | **2004** | ** ** | **over 2004** | ** ** |
| ** **                                           | ** ** | **$**                                      | ** ** | **$**                   | ** ** | **$**                                     | ** ** | **%**                   | ** ** | **$** | ** ** | **$** | ** ** | **$** | ** ** | **%** | ** ** |
| ** **                                           | ** ** | **(dollars in thousands)**                 | ** ** |
| Product sales                                        |       | 1,535                                      |       | 1,221                   |       | 314                                       |       | 26                      |       | 4,660 |   | 4,106 |   | 554 |   | 13 |   |
| Service fees                                         |       | 365                                        |       | 385                     |       | (20                                       | )          | (5                      | )          | 1,165 |   | 1,205 |   | (40 | ) | (3 | ) |
| Total revenues                                       |       | 1,900                                      |       | 1,606                   |       | 294                                       |       | 18                      |       | 5,825 |   | 5,311 |   | 514 |   | 10 |   |
| Product cost of  sales                               |       | 632                                        |       | 379                     |       | 253                                       |       | 67                      |       | 1,784 |   | 1,544 |   | 240 |   | 16 |   |
| Service fees  cost of sales                          |       | 183                                        |       | 171                     |       | 12                                        |       | 7                       |       | 549 |   | 519 |   | 30 |   | 6 |   |
| Total cost of  revenues                              |       | 815                                        |       | 550                     |       | 265                                       |       | 48                      |       | 2,333 |   | 2,063 |   | 270 |   | 13 |   |
| Gross profit                                         |       | 1,085                                      |       | 1,056                   |       | 29                                        |       | 3                       |       | 3,492 |   | 3,248 |   | 244 |   | 8 |   |
| Selling,  general & administrative expenses |       | 739                                        |       | 886                     |       | (147                                      | )          | (17                     | )          | 2,516 |   | 2,742 |   | (226 | ) | (8 | ) |
| Research &  development expenses            |       | 810                                        |       | 616                     |       | 194                                       |       | 31                      |       | 2,030 |   | 1,661 |   | 369 |   | 22 |   |
| Total operating  expenses                            |       | 1,549                                      |       | 1,502                   |       | 47                                        |       | 3                       |       | 4,546 |   | 4,403 |   | 143 |   | 3 |   |
| Other income                                         |       | 67                                         |       | 30                      |       | 37                                        |       | 123                     |       | 183 |   | 138 |   | 45 |   | 33 |   |
| Loss before  taxes                                   |       | (397                                       | )          | (416                    | )          | 19                                        |       | 5                       |       | (871 | ) | (1,017 | ) | 146 |   | 14 |   |
| Provision for  income taxes                          |       | —                                     |       | 20                      |       | (20                                       | )          | (100                    | )          | — |   | 20 |   | (20 | ) | (100 | ) |
| Net loss                                             |       | (397                                       | )          | (436                    | )          | 39                                        |       | 9                       |       | (871 | ) | (1,037 | ) | 166 |   | 16 |   |

 

***Product Sales***

 

TMRlaser revenues, the largest component of product sales in the three and ninemonths ended September 30, 2005, increased by $90,000, or 12%, anddecreased by $189,000, or 11%, respectively, as compared to the three and ninemonths ended September 30, 2004.

 

Inthe three months ended September 30, 2005, the $90,000 increase in TMRlaser revenues is primarily a result of an increase in the number of new TMRlaser units sold by Edwards in the third quarter of 2005 compared to the thirdquarter of 2004, offset in part by decreased revenue sharing earned under theTMR distribution agreement.

 

Inthe nine months ended September 30, 2005, the $189,000 decline in TMRlaser revenues is primarily a result of decreased revenue sharing earned underthe TMR distribution agreement along with a decrease in the number of new TMRlaser units sold by Edwards in the nine months ended September 30, 2005compared to the nine months ended September 30, 2004. These decreases werepartly offset by a higher average domestic selling price on TMR laser sales inthe 2005 period.

 

DisposableTMR kit revenues, the second largest component of product sales, increased by$226,000, or 66%, and $447,000, or 46%, respectively, in the three and ninemonths ended September 30, 2005 as compared to the three and nine monthsended September 30, 2004.  Theincrease in the three months ended September 30, 2005 is primarily relatedto a $274,000, or 96%, increase in domestic disposable revenue.  This $274,000 increase resulted from a highervolume of kit shipments to Edwards along with a $28,000 increase in deferredrevenue amortization related to the $4,533,333 payment by Edwards.International disposable revenue decreased by $48,000, or 87%, in the threemonths ended September 30, 2005 as compared to the three months ended September 30,2004 due to a decrease in the number of TMR kits shipped to internationalcustomers.

 

14

----

 

Theincrease in disposable TMR kit revenues in the nine months ended September 30,2005 is primarily related to a $459,000, or 38%, increase in domesticdisposable revenue.  This $459,000increase resulted from a higher volume of kit shipments to Edwards as well as a$130,000 increase in deferred revenue amortization related to the $4,533,333payment by Edwards. International disposable revenue decreased by $12,000, or11%, in the nine months ended September 30, 2005 as compared to the ninemonths ended September 30, 2004 due to a decrease in the number of TMRkits shipped to international customers.

 

Optiwave980 System revenues from Edwards increased $345,000 in the nine months ended September 30,2005 as compared to the nine months ended September 30, 2004 when we hadno such sales.  The Optiwave 980System revenues we have recognized to date consist of laser power sources soldto Edwards for use in marketing evaluations that they are conducting. We do notexpect any additional significant revenues from Optiwave 980 System salesduring 2005.

 

Otherproduct sales, relating to sales of new and refurbished surgical tubes,decreased $2,000, or 2%, and $49,000, or 13%, respectively, in the three andnine months ended September 30, 2005 as compared to the three and ninemonths ended September 30, 2004.

 

***Service Fee Revenues***

 

Service fee revenuesdecreased $20,000, or 5%, and $40,000, or 3%, in the three and nine monthsended September 30, 2005, respectively, as compared to the three and ninemonths ended September 30, 2004.  Domesticservice fee revenues decreased $32,000, or 9%, and $22,000, or 2%,respectively, in the three and nine months ended September 30, 2005 ascompared to the three and nine months ended September 30, 2004 due to decreasedbillings to Edwards for service related calls. International service fee revenues increased $12,000, or 29%, anddecreased $18,000, or 9%, in the three and nine months ended September 30,2005, respectively, as compared to the three and nine months ended September 30,2004 due to decreased service billings to international customers.

 

***Gross Profit***

 

Totalgross profit was $1,085,000, or 57%, and $3,492,000, or 60%, respectively, oftotal revenues for the three and nine months ended September 30, 2005 ascompared with gross profit of $1,056,000, or 66%, and $3,248,000, or 61%, oftotal revenues, for the three and nine months ended September 30,2004.  The increase in gross profitdollars in the three months ended September 30, 2005 as compared to thethree months ended September 30, 2004 is due to (1) higher disposableTMR revenues, (2) an increase in the number of new TMR lasers sold and (3) anincrease in gross margin generated from other product sales relating to salesof new and refurbished surgical tubes. These increases were offset in part by (1) adecrease in additional revenue sharing earned under the TMR distributionagreement, (2) higher unabsorbed period overhead expenditures, and (3) adecrease in service related revenues.

 

Theincrease in gross profit dollars in the nine months ended September 30,2005 as compared to the nine months ended September 30, 2004 is due to (1) higherdisposable TMR revenues, and (2) a higher average domestic selling priceon TMR laser sales. These increases were offset in part by (1) a decreasein additional revenue sharing earned under the TMR distribution agreement, (2) adecrease in service related revenues, (3) a decrease in gross margingenerated from other product sales relating to sales of new and refurbishedsurgical tubes and (4)

 

15

----

 

higher unabsorbed period overhead expenditures.

 

***Selling, General and AdministrativeExpenses***

 

Selling,general and administrative expenses decreased 17% and 8%, respectively, in thethree and nine months ended September 30, 2005 as compared to the threeand nine months ended September 30, 2004. In the three month period, thedecrease is primarily a result of decreased expenditures related to salary andrelated fringe benefits, bad debt expense and legal fees.  In the nine-month period, the decrease isrelated to lower legal and administrative fees and bad debt expense offset inpart by increased insurance expenditures.

 

***Research and Development Expenses***

 

Research and developmentexpenses increased 31% and 22%, respectively, in the three and nine monthsended September 30, 2005 as compared to the three and nine months ended September 30,2004.  The increased expenditures were incurredprimarily in connection with product development work on an additional internalresearch and development initiative.

 

***Other Income***

 

Thelargest component of other income is interest income earned on our cash and short-and long-term investments. Interest income increased by $37,000 and $97,000,respectively, in the three and nine months ended September 30, 2005compared to the three and nine months ended September 30, 2004 due tohigher average interest rates earned on our invested cash and short- andlong-term investments. Other income for the nine months ended September 30,2005 was negatively impacted in comparison to the comparable period in 2004 asa result of a $52,000 insurance settlement received in the second quarter of2004.

 

***Net Loss***

 

Thedecrease in the net loss in the three and nine month periods ended September 30,2005 resulted primarily from higher gross margin dollars generated and higherother income offset in part by higher operating expenses.

 

***Kit Shipments***

 

Weview disposable kit shipments to end users as an important metric in evaluatingour business.  We believe kit shipmentsare a reasonable indicator for the adoption of TMR as a therapy in themarketplace.  Disposable kit shipments toend users during the three and nine months ended September 30, 2005 and September 30,2004 were as follows:

 
| ** **    | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|---------------|------------|-------------------------------------------|------------|------------------------------------------|------------|
| ** **    | ** ** | **2005**                                  | ** ** | **2004**                                 | ** ** | **% Increase  (Decrease)  over 2004** | ** ** | **2005** | ** ** | **2004** | ** ** | **% Increase  (Decrease)  over 2004** | ** ** |
|          |       |                                      |       |                                     |       |   |   |   |   |   |   |   |   |
| Domestic      |       | 513                                       |       | 539                                      |       | (5 | ) | 1,518 |   | 1,423 |   | 7 |   |
| International |       | 15                                        |       | 53                                       |       | (72 | ) | 70 |   | 99 |   | (29 | ) |
| Total         |       | 528                                       |       | 592                                      |       | (11 | ) | 1,588 |   | 1,522 |   | 4 |   |

 

16

----

 

**Liquidityand Capital Resources**

 

At September 30,2005, we had cash, cash equivalents and short- and long-term investments of $9,717,000.  Our short- and long-term investments consistof monies invested in bank certificates of deposit.  We have no debt obligations.

 

During the nine-monthperiod ended September 30, 2005, we recorded a net loss of $871,000.  We had net favorable working capital changes aswell as non-cash depreciation and amortization charges which resulted in netcash provided by operating activities of approximately $113,000. Cash used ininvesting activities was approximately $6,932,000, consisting of the purchaseof investments of $8,400,000 and $32,000 of investments in equipment offset inpart by a maturity of an investment of $1,500,000.  We believe that our existing cash resourceswill meet our working capital requirements through the next 12 months.

 

Weare largely dependent on the success of Edwards’ sales and marketing efforts inthe U.S. to continue to increase the installed base of HL2 lasers andsubstantially increase TMR procedural volumes and revenues. Should theinstalled base of HL2 lasers or TMR procedural volume not increasesufficiently, our liquidity and capital resources will be negativelyimpacted.  Additionally, otherunanticipated decreases in operating revenues or increases in expenses orchanges or delays in third-party reimbursement to healthcare providers usingour products may adversely impact our cash position and require further costreductions or the need to obtain additional financing.  It is not certain that we, working withEdwards and our international distributors, will be successful in achieving broadcommercial acceptance of the Heart Laser Systems, or that we will be able tooperate profitably in the future on a consistent basis, if at all.

 

Some hospital customers prefer to acquire the HeartLaser Systems on a usage basis rather than as a capital equipmentpurchase.  We believe this is the resultof limitations many hospitals currently have on acquiring expensive capitalequipment as well as competitive pressures in the marketplace.  A usage business model will result in alonger recovery period for Edwards to recoup its investment in lasers itpurchases from us.  This results in (1) adelay in our ability to receive additional shared revenue, if any, that weotherwise are entitled to receive under the terms of our distribution agreementwith Edwards (see “Critical Accounting Policies and Estimates – RevenueRecognition”) and (2) a delay in the purchase of new lasers by Edwards ifits installed base of lasers placed under usage contracts are under-performingand it chooses to re-deploy these lasers to other hospital sites in lieu ofpurchasing a new laser from us.  Our cashposition and our need for additional financing to fund operations will bedependent in part upon the number of hospitals that acquire Heart Laser Systemsfrom Edwards on a usage basis and the number and frequency of TMR proceduresperformed by these hospitals.

 

Furthermore, we have undertaken a new businessstrategy that involves broadening and diversifying our product portfolio beyondour current TMR offerings, by developing or acquiring new and innovativemedical devices to address cardiac and vascular related markets. We believethis strategy will result in our incurring losses for at least the next 12-24months as we increase our spending in the area of research and development. Wecannot be certain that we will be successful in implementing our new businessstrategy or that future sales, if any, from these planned new products willrecover the investments we plan to make. If we are unsuccessful in implementingour new business strategy, or if the diversification of our product portfoliotakes longer or costs more than anticipated, our

 

17

----

 

liquidity and capital resources will be adversely affected and we mayneed to obtain additional financing.

 

Therecan be no assurance that, should we require additional financing, suchfinancing will be available on terms and conditions acceptable to us.  Should additional financing not be availableon terms and conditions acceptable to us, additional actions may be requiredthat could adversely impact our ability to continue to realize assets andsatisfy liabilities in the normal course of business.  The consolidated financial statements setforth in this report do not include any adjustments to reflect the possiblefuture effects of these uncertainties.

 

**Off-BalanceSheet Arrangements**

 

None.

 

## **CertainFactors that May Affect our Future Results**

## ** **

Therisks and uncertainties described below are not the only risks we face.  Additional risks and uncertainties notpresently known to us or currently deemed immaterial may also impair ourbusiness operations.  If any of thefollowing risks actually occur, our financial condition and operating resultscould be materially adversely affected.

 

***We expect to incur significantoperating losses in the near future***

 

Weincurred a net loss in the quarter ended September 30, 2005.  We expect to continue to incur net losses forat least the next 12-24 months as we increase our spending in the area ofresearch and development. Moreover, as we continue to pursue our new businessstrategy of acquiring or developing new medical devices to address cardiac andvascular related markets, we may continue to incur expenses that exceed therevenues we generate.  We cannot provideany assurance that we will be successful with our new business strategy or thatwe will ever return to profitability.

 

***Our company is currently dependenton one principal product line to generate revenues***

 

Wecurrently market one product line, which consists of two patented high-poweredcarbon dioxide lasers and related TMR disposable kits known as the Heart LaserSystems, which account for the majority of our total revenue.  Approximately 93% and 88%, respectively, ofour revenues in the three and nine months ended September 30, 2005 and 90%in the year ended December 31, 2004, were derived from the sales and service ofour Heart Laser Systems.  This absence ofa diversified product line means that we are directly and materially impactedby changes in the market for Heart Laser Systems.

 

***Our company is dependent on oneprincipal customer***

 

Pursuantto the terms of our TMR distribution agreement with Edwards, Edwards is ourexclusive distributor for our HL2 TMR laser and TMR kits in the UnitedStates.  In addition, pursuant to theterms of our 2004 distribution agreement with Edwards for the Optiwave 980System (as well as any other additional surgical products that we may developfor the treatment of atrial fibrillation, or AF), Edwards is our exclusiveworldwide distributor of those products, if and when introduced for sale.  As a result of these exclusive distributionarrangements, Edwards

 

18

----

 

accounted for 88% and 89% of our total revenues in the three and ninemonths ended September 30, 2005, respectively, and 88% in the year ended December 31,2004 and we expect Edwards to account for the significant majority of ourrevenue in the future.  If ourrelationship with Edwards does not progress as anticipated, or if Edwards’sales and marketing strategies fail to generate sales of our products in thefuture, our revenue will decrease significantly and our business, financialcondition and results of operations will be seriously harmed.

 

***Edwards must successfully completetheir marketing evaluations of the Optiwave 980 System before they commit tolaunch the product***

 

Edwardsis currently conducting marketing evaluations of the Optiwave 980 System athospitals across the country. Edwards must complete these marketing evaluationsand judge them to be successful before they will commit to launch the productinto the market.  We cannot assure youthat Edwards will successfully complete these marketing evaluations of theOptiwave 980 System or that they will not decide to cancel the program in thefuture. Should Edwards decide for whatever reason not to market the Optiwave980 System, our near term revenue growth prospects, financial condition andresults of operations could be materially and adversely affected.

 

***Our company is dependent on certain suppliers***

 

Some of the components for our Heart Laser Systems,most notably the power supply and certain optics and fabricated parts for theHL2, and certain components for the Optiwave 980 System, are only availablefrom one supplier, and we have no assurance that we will be able to source anyof our sole-sourced components from additional suppliers.  We are dependent upon our sole suppliers toperform their obligations in a timely manner. In the past, we have experienced delays in product delivery from oursole suppliers and, because we do not have an alternative supplier to producethese products for us, we have little leverage to enforce timely delivery. Anydelay in product delivery or other interruption in supply from these supplierscould prevent us from meeting our commercial demands for our products, whichcould have a material adverse effect on our business, financial condition andresults of operations.  Furthermore, wedo not require significant quantities of any components because we produce alimited number of our products each year. Our low-quantity needs may not generate substantial revenue for oursuppliers.  Therefore, it may bedifficult for us to continue our relationships with our current suppliers orestablish relationships with additional suppliers on commercially reasonableterms, if at all, and such difficulties may seriously harm our business,financial condition and results of operations.

 

***We must transition manufacturing ofthe Optiwave 980 disposable handpieces from Edwards and be able to manufacturethem in required volumes at commercially reasonable costs***

 

Assuming Edwardssuccessfully completes their marketing evaluations of the Optiwave 980 System,we must successfully transition production of the Optiwave 980 disposablehandpieces from Edwards’ manufacturing facility. We must hire new skilledmanufacturing employees and we must develop and validate our manufacturingprocesses with respect to building these disposable handpieces.  In order to meet these obligations, we wouldneed to incur expenses to outfit our manufacturing space with the necessaryproduction and test equipment and to train our employees on how to build theproduct. We will need to be able to manufacture these highly specializeddisposable handpieces for which we have no comparable prior experienceproducing at any volume. Until such time as we become more proficient in thesemanufacturing methods, if ever, we may

 

19

----

 

encounter problems, including those related to:

 

•      production yields;

•      quality control;

•      training;

•      shortages of qualifiedpersonnel; and

•      potential capacityconstraints.

 

Such problems couldseverely affect our ability to adequately scale up production and meet demandfor our products on a timely basis, which could harm our business, financialcondition and results of operations.

 

***We are dependent upon our key personnel andwill need to hire additional key personnel in the near future***

 

Our ability to operate ourbusiness successfully depends in significant part upon the retention andmotivation of certain key technical, regulatory, production and managerialpersonnel and consultants and our ongoing ability to hire and retain additionalqualified personnel in these areas. Competition for such personnel is intense,particularly in the Greater Boston area. We cannot be certain that we will beable to attract such personnel and the loss of any of our current key employeesor consultants could have a significant adverse impact on our business.

 

***Our company may be unable to raiseneeded funds***

 

Asof September 30, 2005, we had cash, cash equivalents and short- andlong-term investments totaling $9,717,000. Based on our current operating plan,we anticipate that our existing capital resources should be sufficient to meetour working capital requirements for at least the next 12 months.  However, if our business does not progress inaccordance with our current business plan, we may need to raise additionalfunds in the future.  We may not be ableto raise additional capital upon satisfactory terms, or at all, and ourbusiness, financial condition and results of operations could be materially andadversely affected.  To the extent thatwe raise additional capital by issuing equity or convertible securities,ownership dilution to our shareholders will result.  To the extent that we raise additionalcapital through the incurrence of debt, our activities may be restricted by therepayment obligations and other restrictive covenants related to the debt.

 

***In order to compete effectively, ourcurrent and future products need to gain commercial acceptance***

 

TMRand surgical ablation for cardiac arrhythmias are still both emergingtechnologies.  Our current and plannedfuture products may never achieve widespread commercial acceptance.  To be successful, we need to:

 

•      demonstrate to the medical community ingeneral, and to heart surgeons and cardiologists in particular, that TMR andsurgical tissue ablation for cardiac arrhythmias are procedures that areeffective, relatively safe and cost effective;

 

•      support third-party efforts to document themedical processes by which TMR procedures relieve angina and surgical tissueablation cures cardiac arrhythmias;

 

20

----

 

•      have more heart surgeons trained to performTMR procedures using the Heart Laser Systems and surgical tissue ablationprocedures using the Optiwave 980 System; and

 

•      maintain and expand third-party reimbursementfor the TMR procedure.

 

Todate, only a limited number of heart surgeons have been trained in the use ofTMR using the Heart Laser Systems and cardiac tissue ablation procedures usingthe Optiwave 980 System.  We aredependent on Edwards to expand related marketing and training efforts in theU.S. for the use of our products.

 

TheHeart Laser Systems have not yet received widespread commercialacceptance.  We believe that concernsover the lack of a consensus view on the reason or reasons why a TMR procedurerelieves angina in patients who undergo the procedure has limited demand forand use of the Heart Laser Systems. Until there is consensus, if ever, of themedical processes by which TMR procedures relieve angina, we believe somehospitals may delay the implementation of a TMR program.

 

Ifwe are unable to achieve widespread commercial acceptance of the Heart LaserSystems or the Optiwave 980 System, our business, financial condition andresults of operations will be materially and adversely affected.

 

***Our primary competitor in TMR mayobtain FDA approval to market a new device, the impact of which is uncertain onthe future adoption rate of TMR***

 

Ourprimary TMR competitor, CardioGenesis, is attempting to obtain FDA approval tomarket their “percutaneous” method of performing myocardial revascularization,previously known as PMR, and recently rebranded as PMC (percutaneous myocardialchanneling), which would provide a less invasive method of creating channels inthe heart.  If PMC can be shown to be safe and effective and is approved bythe FDA, it would eliminate the need in certain patients to make an incision inthe chest, reducing costs and speeding recovery.  It is unclear what impact, if any, anapproval of a PMC device would have on the future adoption rate for TMRprocedures. If PMC is approved, it could erode the potential TMR market whichwould have a material adverse effect on our business, financial condition andresults of operations.

 

***Rapid technological changes in ourindustry could make our products obsolete***

 

Ourindustry is characterized by rapid technological change and intensecompetition.  New technologies andproducts and new industry standards will develop at a rapid pace, which couldmake our current and future planned products obsolete. The advent of newdevices and procedures and advances in new drugs and genetic engineering areespecially concerning competitive threats. Our future success will depend upon our ability to develop and introduceproduct enhancements to address the needs of our customers.  Material delays in introducing productenhancements may cause customers to forego purchases of our products andpurchase those of our competitors.

 

Manypotential competitors have substantially greater financial resources and are ina better financial position to exploit marketing and research and developmentopportunities.  In addition, we are awarethat other companies are developing or already have developed proprietarysystems for the treatment of cardiac arrhythmias, and specifically AF, that maybe

 

21

----

 

safer, clinically more effective, easier and more cost effective to useand, in the case of percutaneous devices, less invasive than the system we aredeveloping.

 

***We must receive and maintaingovernment clearances or approvals in order to market our products***

 

Ourproducts and our manufacturing activities are subject to extensive, rigorousand changing federal and state regulation in the U.S. and to similar regulatoryrequirements in other major international markets, including the European Unionand Japan.  These regulations andregulatory requirements are broad in scope and govern, among other things:

 

•      product design and development;

•      product testing;

•      product labeling;

•      product storage;

•      premarket clearance and approval;

•      advertising and promotion; and

•      product sales and distribution.

 

Furthermore,regulatory authorities subject a marketed product, its manufacturer and themanufacturing facilities to continual review and periodic inspections.  We are subject to ongoing FDA requirements,including required submissions of safety and other post-market information andreports, registration requirements, Quality Systems regulations, andrecordkeeping requirements. The FDA’s Quality Systems regulations includerequirements relating to quality control and quality assurance, as well as thecorresponding maintenance of records and documentation.  Edwards, our distributor, depending on itsactivities, is also subject to certain requirements under the Federal Food,Drug, and Cosmetic Act and the regulations promulgated thereunder, and statelaws and registration requirements covering the distribution of our products.Regulatory agencies may change existing requirements or adopt new requirementsor policies that could affect our regulatory responsibilities or the regulatoryresponsibilities of a distributor like Edwards. We may be slow to adapt or may not be able to adapt to these changes ornew requirements.

 

Laterdiscovery of previously unknown problems with our products, manufacturingprocesses, or our failure to comply with applicable regulatory requirements mayresult in enforcement actions by the FDA and other international regulatoryauthorities, including, but not limited to:

 

•      warning letters;

•      patient or physician notification;

•      restrictions on our products or manufacturingprocesses;

•      voluntary or mandatory recalls;

•      product seizures;

•      refusal to approve pending applications orsupplements to approved applications that we submit;

•      refusal to permit the import or export of ourproducts;

•      fines;

•      injunctions;

 

22

----

 

•      suspension or withdrawal of marketingapprovals or clearances; and

•      civil and criminal penalties.

 

Shouldany of these enforcement actions occur, our business, financial condition andresults of operations could be materially and adversely affected.

 

Todate, we have received the following regulatory approvals for our products:

 

***Heart Laser Systems***

 

*United States —*We received FDA approval to market the HL1 Heart Laser System in August 1998and the HL2 Heart Laser System in January 2001.  However, although we have received FDAapproval, the FDA:

 

•      has restricted the use of the Heart LaserSystems by not allowing us to market these products to treat patients whosecondition is amenable to conventional treatments, such as heart bypass surgery,stenting and angioplasty; and

 

•      could impose additional restrictions orreverse its ruling and prohibit use of the Heart Laser Systems at any time.

 

*Europe —*We received the CE Mark from the European Union for the HL1 and HL2 in March 1995and February 2001, respectively. However:

 

•      the European Union could impose additionalrestrictions or reverse its ruling and prohibit use of the Heart Laser Systemsat any time; and

 

•      France has prohibited, and other EuropeanUnion countries could prohibit or restrict, use of the Heart Laser Systems.

 

*Japan —*We cannot market our product in Japan until we receive governmentapproval.

 

Priorto marketing the Heart Laser Systems in Japan, we must receive approval fromthe Japanese government. This approval requires a clinical study in Japan withat least 60 patients.  A study wascompleted in 1998 with the HL1. Although the results of this study have beensubmitted to the Japanese government, we do not know whether the clinical studywill be sufficient or when, if ever, we will receive approval to sell the HL1in Japan. In addition, it is unclear what impact the introduction of the HL2into the U.S. and other international markets will have on our ability tomarket the HL1 in Japan.

 

***Optiwave 980 System***

 

*United States —*The FDA has givenclearance to the Optiwave 980 System through the 510(k) premarket notificationprocess with indications for use as a surgical instrument for coagulation ofsoft tissue, including cardiac tissue, in conjunction with or withoutendoscopic equipment in the contact or non-contact mode in open or closedsurgical procedures.

 

Although we have received clearance from the FDAonly for the indications of use stated above, physicians, under the practice ofmedicine exception, may use the Optiwave 980 System in any manner they choosein treating an individual patient, including using the device to treat patients

 

23

----

 

with AF.  However, neither we norEdwards have conducted any clinical trials designed to obtain data to submit tothe FDA for the purpose of obtaining a specific indication for use of theOptiwave 980 System that would allow us to make claims or otherwise market thisdevice for the treatment of AF. We are aware of several other companies thathave announced their plans to conduct clinical trials in support of a labelingclaim that would allow them to market their devices for the treatment of AF ifclearance is obtained from the FDA.

 

In the event these other competitors are successfulin obtaining specific indications of use for their devices in the treatment ofAF, the Optiwave 980 System may be at a competitive marketing disadvantageuntil such time, if ever, that Edwards conducts a clinical trial, submitssufficient data to the FDA by means of a new 510(k) and obtains clearance tomarket the Optiwave 980 System for the treatment of AF. We cannot provide anyassurance that Edwards will ever conduct such a clinical trial or, if they do,that the data they obtain and submit to the FDA will be sufficient for the FDAto expand the current indications of use and provide clearance for the Optiwave980 System to be marketed for the treatment of AF. Also, we cannot assure youthat even if such clearance is obtained, that it will be obtained in a timelyenough fashion for our products to remain competitive in the marketplace.

 

*Europe —*The Optiwave 980 Systemcannot be marketed in the EU until such time as it receives CE Mark approval.We need to complete and submit the relevant technical documentation to theappropriate certifying body in order to be able to apply the CE Mark that, ifgranted, will enable the product to be distributed in the EU.

 

***Changes in thirdparty reimbursement for our TMR procedure could materially affect future demandfor our TMR products***

 

Currently,Medicare and Blue Cross Blue Shield provide coverage for TMR when it isperformed as both a sole therapy treatment and when used as an adjunct to bypasssurgery. Certain other private insurance companies and health maintenanceorganizations also currently provide reimbursement for these TMR proceduresperformed with our products, and physician reimbursement codes have beenestablished for both surgical procedures; however, we have limited data as tothe breadth of this coverage for the TMR procedures by private insurancecompanies and health maintenance organizations. Should third party insurancereimbursement for our TMR products be reduced or eliminated in the future, ourbusiness, financial condition and results of operations would be materially andadversely affected.

 

InJuly 2004, CMS convened the Medicare Coverage Advisory Committee (MCAC) toreview and discuss the evidence and clinical data regarding TMR. The MCAC is anadvisory panel consisting of clinicians and other medical experts which CMSutilizes to supplement their own internal expertise. Although the MCAC was notconvened for the purpose of making a reimbursement coverage recommendation, webelieve CMS has reviewed the information presented at the MCAC meeting and hasdecided to continue existing Medicare coverage for TMR without anymodification. No assurance can be given that CMS will not choose to alterMedicare coverage in the future, which could include (1) issuing newguidelines clarifying the patient criteria for Medicare reimbursement, (2) reducing,modifying or eliminating the existing reimbursement coverage for TMR or (3) requestingadditional clinical studies to be performed.

 

24

----

 

***Asserting and defending intellectualproperty rights may impact our results of operations***

 

Inour industry, competitors often assert intellectual property infringementclaims against one another.  The successof our business depends on our ability to successfully defend our intellectualproperty.  Future litigation may have amaterial impact on our financial condition even if we are successful inmarketing our products. We may not be successful in defending or asserting ourintellectual property rights.

 

Anadverse outcome in any litigation or interference proceeding could subject usto significant liabilities to third parties and require us to cease using thetechnology that is at issue or to license the technology from thirdparties.  In addition, a finding that anyof our intellectual property is invalid could allow our competitors to moreeasily and cost-effectively compete with us. Thus, an unfavorable outcome in any patent litigation or interference proceedingcould have a material adverse effect on our business, financial condition orresults of operations.

 

Thecost to us of any patent litigation or interference proceeding could besubstantial.  Uncertainties resultingfrom the initiation and continuation of patent litigation or interferenceproceedings could have a material adverse effect on our ability to compete inthe marketplace.  Patent litigation andinterference proceedings may also absorb significant management time.

 

***We may be subject to productliability lawsuits; our insurance may not be sufficient to cover damages***

 

Wemay be subject to product liability claims. Such claims may absorb significant management time and could degrade ourreputation and the marketability of our products.  If product liability claims are made withrespect to our products, we may need to recall the implicated product whichcould have a material adverse effect on our business, financial condition andresults of operations. In addition, although we maintain product liabilityinsurance, we cannot be sure that our insurance will be adequate to coverpotential product liability lawsuits. Our insurance is expensive and in thefuture may not be available on acceptable terms, if at all. If a successfulproduct liability claim or series of claims exceeds our insurance coverage, itcould have a material adverse effect on our business, financial condition andresults of operations.

 

***We are subject to risks associatedwith international operations***

 

Aportion of our product sales are generated from operations outside of theU.S.  Establishing, maintaining andexpanding international sales can be expensive. Managing and overseeing foreign operations are difficult and productsmay not receive market acceptance.  Risksof doing business outside the U.S. include, but are not limited to, thefollowing: agreements may be difficult to enforce and receivables difficult tocollect through a foreign country’s legal system; foreign customers may havelonger payment cycles; foreign countries may impose additional withholdingtaxes or otherwise tax our foreign income, impose tariffs or adopt otherrestrictions on foreign trade; U.S. export licenses may be difficult to obtain;and the protection of intellectual property rights in foreign countries may bemore difficult to enforce.  There can beno assurance that our international business will grow or that any of theforegoing risks will not result in a material adverse effect on our business orresults of operations.

 

25

----

 

***Because we are incorporated inCanada, you may not be able to enforce judgments against us and our Canadiandirectors***

 

UnderCanadian law, you may not be able to enforce a judgment issued by courts in theU.S. against us or our Canadian directors. The status of the law in Canada isunclear as to whether a U.S. citizen can enforce a judgment from a U.S. courtin Canada for violations of U.S. securities laws. A separate suit may need tobe brought directly in Canada.

 

***Our stock price has historicallyfluctuated and may continue to fluctuate significantly in the future which mayresult in losses for our investors***

 

Ourstock price has been and may continue to be volatile. Some of the factors thatcan affect our stock price are:

 

•      the announcement of new products, services ortechnological innovations by us or our competitors;

•      actual or anticipated quarterly increases ordecreases in revenue, gross margin or earnings, and changes in our business,operations or prospects;

•      speculation or actual news announcements inthe media or industry trade journals about our company, our products, the TMRor cardiac ablation procedures or changes in reimbursement policies by Medicareand/or private insurance companies;

•      announcements relating to strategicrelationships or mergers;

•      conditions or trends in the medical deviceindustry;

•      changes in the economic performance or marketvaluations of other medical device companies; and

•      general market conditions or domestic orinternational macroeconomic and geopolitical factors unrelated to ourperformance.

 

***The market price of our stock mayfall if shareholders sell their stock***

 

Certaincurrent shareholders hold large amounts of our stock, which they could sell inthe public market from time to time.  Salesof a substantial number of shares of our common stock within a short period oftime could cause our stock price to fall. In addition, the sale of these shares could impair our ability to raisecapital through the sale of additional stock.

 

***We have no intention to pay dividends***

 

Wehave never paid any cash dividends on our common stock. We currently intend toretain all future earnings, if any, for use in our business and do not expectto pay any dividends in the foreseeable future.

 

**Item 3.****    Quantitative and Qualitative Disclosures aboutMarket Risk**

 

A portion of our operations consists of sales activities in foreignjurisdictions.  We manufacture ourproducts exclusively in the U.S. and sell our products in the U.S. and abroad.As a result, our financial results could be affected by factors such as changesin foreign currency exchange rates or weak economic conditions in the foreignmarkets in which we distribute our products. Our operating results are exposed to changes in exchange rates betweenthe U.S. dollar and foreign currencies, especially the Euro. When the U.S.dollar strengthens against the Euro, the

 

26

----

 

value of foreign sales decreases. When the U.S. dollar weakens, thefunctional currency amount of sales increases. No assurance can be given thatforeign currency fluctuations in the future will not adversely affect ourbusiness, financial condition and results of operations, although at present wedo not believe that our exposure is significant as international salesrepresented only 6% of our consolidated sales in the three and nine monthsended September 30, 2005 as well as in the year ended December 31,2004. We do not hedge any balance sheet exposures and intercompany balancesagainst future movements in foreign exchange rates.

 

Ourinterest income and expense are sensitive to changes in the general level ofU.S. and foreign interest rates. In this regard, changes in U.S. and foreigninterest rates affect the interest earned on our cash and cashequivalents.  We do not believe that a10% change to the applicable interest rates would have a material impact on ourfuture results of operations or cash flows.

 

## **Item 4.**    Controls and Procedures

## ** **

Our management, with the participation of our chief executive officerand chief financial officer, evaluated the effectiveness of our disclosurecontrols and procedures as of September 30, 2005.  The term “disclosure controls and procedures”,as defined in Rules 13a-15(e) and 15d-15(e) under the ExchangeAct, means controls and other procedures of a company that are designed toensure that information required to be disclosed by a company in the reportsthat it files or submits under the Exchange Act is recorded, processed,summarized and reported within the time periods specified in the SEC’s rules andforms.  Disclosure controls andprocedures include, without limitation, controls and procedures designed toensure that information required to be disclosed by a company in the reportsthat it files or submits under the Exchange Act is accumulated and communicatedto the company’s management, including its principal executive and principalfinancial officers, as appropriate to allow timely decisions regarding requireddisclosure.  Management recognizes thatany controls and procedures, no matter how well designed and operated, canprovide only reasonable assurance of achieving their objectives and managementnecessarily applies its judgment in evaluating the cost-benefit relationship ofpossible controls and procedures.  Basedon the evaluation of our disclosure controls and procedures as of September 30,2005, our chief executive officer and chief financial officer concluded that,as of such date, our disclosure controls and procedures were effective at thereasonable assurance level.

 

No change in our internal control over financialreporting (as defined in Rules 13a-15(f) and 15d-15(f) under theExchange Act) occurred during the fiscal quarter ended September 30, 2005that has materially affected, or is reasonably likely to materially affect, ourinternal control over financial reporting.

 

27

----

 

**Part II.  Other Information**

 

**Item 6.****    Exhibits**

 
| 31.1   |   | Certification  of Chief Executive Officer pursuant to Rule 13a-14(a) or Rule 15d-14(a) of  the Securities Exchange Act of 1934, as adopted pursuant to Section 302  of the Sarbanes-Oxley Act of 2002. |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                            |
| 31.2   |   | Certification  of Chief Financial Officer pursuant to Rule 13a-14(a) or  Rule 15d-14(a) of the Securities Exchange Act of 1934, as adopted  pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |
|   |   |                                                                                                                                                                                                                            |
| 32.1   |   | Certifications  pursuant to 18 U.S.C. Section 1350, as adopted pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                            |

 

28

----

 

**SIGNATURES**

 

Pursuantto the requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.

 
|   | PLC SYSTEMS INC.        |
|--------|-------------------------|
|   |                    |
|   |                    |
| Date:  | November 14,  2005 | By: |  /s/  James G. Thomasch |   |
|   |                    |  James  G. Thomasch |
|   |                    |  Chief  Financial Officer   (Principal Financial  Officer and Chief   Accounting Officer) |
|        |                         |  |  |  |

 

29

----

 

**EXHIBIT INDEX**

 
| **Exhibit**Number | ** ** | **Description of Document**                                                                                                                                                                                           |
|-------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** **        | ** ** | ** **                                                                                                                                                                                                            |
| 31.1              |       | Certification  of Chief Executive Officer pursuant to Rule 13a-14(a) or  15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002. |
|              |       |                                                                                                                                                                                                                  |
| 31.2              |       | Certification  of Chief Financial Officer pursuant to Rule 13a-14(a) or  15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002. |
|              |       |                                                                                                                                                                                                                  |
| 32.1              |       | Certifications  pursuant to 18 U.S.C. Section 1350, as adopted pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                  |

 

30

----